Data-dependent, that was perhaps the word we heard most often from the president of the European Central Bank (ECB) in recent months. The term describes the ECB’s modus operandi: the bank would decide what to do with interest rates on a meeting-by-meeting basis, and depending on a variety of macroeconomic data on, for instance, inflation and labour cost developments.
In early June, the ECB board decided to cut interest rates, by 25 basis points. And that can be called remarkable, to say the least. ‘Remarkable’ because labour costs rose harder in the first quarter than in the last three months of 2023. On the contrary, the ECB has time and again cited a fall in it as justification for cutting interest rates. ‘Remarkable’ because inflation rebounded in May. And also ‘remarkable’ since ECB economists raised their estimate for inflation in 2024 and 2025.
No wonder ECB president Christine Lagarde was asked quite a few questions about this. The explanations provided for why interest rates did go down are bizarre, to say the least.
For instance, some board members said they had agreed to it because the ECB had been announcing an interest rate cut in June for months. How that can be reconciled with data-dependent operations, I wouldn’t know. Another reason cited is that ECB staff estimates of inflation at the end of 2025 have been virtually unchanged for some time. The third reason mentioned was that the ECB’s confidence that inflation will fall has increased.
The decision to cut interest rates, despite all the developments mentioned, gives the impression that the considerations may have been other than monetary alone. Like the high debt levels in many eurozone countries. And in some countries, the situation is dire in this regard, as seen in the recent downgrading of France’s credit rating.
Speaking of remarkable things regarding the ECB, Lagarde said several times during the press conference that annual inflation halved between when the ECB started raising interest rates, in July 2022, and when it stopped, in September 2023. Inflation then halved again between that time and today’s cut. The ECB president spoke of it in the terms that “we [by which she meant the ECB] managed that”.
While factually correct, that claim is noteworthy. And here’s why:
Inflation is the change in prices at a given time compared to a year earlier. As energy prices spiked to unprecedented heights in 2022, it meant that inflation would have automatically tumbled down in 2023 had energy prices alone remained unchanged, even if they had remained at unprecedented levels. Indeed, the contribution to inflation after some time had been as low as 0 per cent. That’s simple maths.
If gas prices rise from 50 cents to 3 euros, that drives up inflation because statisticians look at the percentage increase to calculate inflation. And that, in the example cited, is 500 per cent. If the gas price then stays at that 3 euros, gas is still extremely expensive but the percentage price change would be 0 per cent after 12 months. So there would be, from that angle, solid downward pressure on inflation.
What the ECB is doing with a comment like Lagarde’s is fluffing other people’s feathers. If the drop in inflation were really due to ECB policy, then by now, with that favourable statistical energy effect having fallen away, we should still be seeing inflation falling.
But we don’t see that. In fact, entirely coincidentally, the decline in inflation stops exactly when the favourable energy effect runs out and inflation has been rising ever since. This suggests that the ECB has been too lenient rather than too strict in the war on inflation and, by extension, that the bank may have stopped fighting inflation too early. There is more to be said for the stance of the Australian central bank, which does not rule anything out with regard to interest rates, or for comments by some members of the Fed’s interest rate committee who openly question whether interest rates should not be raised again.
Looking at the period since the summer of 2021, we can see, in my view, that the ECB has made some gross and potentially costly mistakes.
The first mistake is the “inflation is temporary” story of between summer 2021 and spring 2022, when even birds in the sky knew that it made no sense.
By continuing to repeat and believe this monetary fairy tale, the ECB started raising interest rates too late to fight inflation, which is mistake number two. Then, in my view, the bank stopped raising interest rates too early and started shorting them too early, mainly because the ECB committed itself to that move with the “interest rates will go down in June 2024” promise, even though the bank indicated it was operating data-dependent.
In my view, these are too many and too big mistakes to throw it on “where work is done, mistakes are made”. Rather, one can speak of incompetence, or being too political. The future consequences of the mistakes mentioned could range from too long, too high inflation in the eurozone (I hope to be wrong) to even the break-up of the currency union.
Edin Mujagić is an economist, manager of Hoofbosch Investment Fund and author of the book Turning Point 1971. He writes an ECB Watch on European Central Bank monetary policy every month for Investment Officer.